Saturday, December 09, 2006

Fundamental Analysis

Fundamental analysis of a business involves analyzing its financial statements and health, its management and competitive advantages, and its competitors and markets.The objectives of the analysis may be to calculate credit risk, to evaluate management and make internal business decisions, or to determine the value of a company's stock and its probable future. The analysis is performed on historical and present data, but the objective is to predict future stock or business performance.

Two analytical models:When the objective of the analysis is to determine what stock to buy and at what price, there are two basic methodologies.

Fundamental analysis maintains that markets may misprice a security in the short run but that the "correct" price will eventually be reached. Profits can be made by trading the mispriced security and then waiting for the market to recognize its "mistake" and reprice the security. Even if the investor believes he cannot beat the market index, he may still pick stock for the challenge, for the fun of trying, and for the ego rush when he does beat the market.

Technical analysis maintains that all information is reflected already in the stock price, so fundamental analysis is a waste of time. Trends 'are your friend' and sentiment changes predate and predict trend changes. Investors' emotional responses to price movements lead to recognizable price chart patterns. Technical analysis does not care what the 'value' of a stock is. Their price predictions are only extrapolations from historical price patterns.

Investors can use both these different but somewhat complementary methods for stock picking. Many fundamental investors use technicals for deciding entry and exit points. Many technical investors use fundamentals to limit their universe of possible stock to 'good' companies.The choice of stock analysis is determined by the investor's belief in the different paradigms for "how the stock market works".